What are bitcoins?

Bitcoins (BTC) are essentially a form of money, but the difference compared to the notes and bankcoins that you use in daily life, is that bitcoins are purely digital (or virtual).

Bitcoins are a virtual currency which is created and exchanged through a peer-to-peer computer network with no need for a central administration.

The money that you use everyday is usually exchanged via banks and financial institutions, as well as psychically handling cash.

Bitcoins, however, are exchanged through what is called a peer-to-peer network of computers. This is similar to any file-sharing system that people use to transfer large files (movies, songs or games) with each other through the internet.

In other words, each computer in the system works as a 'client' for other computers. This means that bitcoins are not controlled by any central authority or government.

Whereas a central government or authority would monitor payments and create the money that circulates in the economy, the bitcoin network itself monitors payments and produces the supply of bitcoins.

How can you use bitcoins?

In order to use bitcoins, you have to download a free software from the internet which is called the 'digital wallet'. You use this wallet like your normal online bank account, except that you make and receive payments which are denominated in bitcoins.

Using bitcoins is fast, anonymous and has transaction costs close to zero. You can trade them against normal currencies through dedicated exchanges.

Transactions are carried out directly from user to user – there are no banks or financial institutions in between. This is just like you handing your friend some cash, but it is done electronically instead.

This is faster and with zero costs compared to conventional payment systems, where central institutions charge fees for their administrative services (for clearing and settlement).

Bitcoins are considered to be anonymous. In fact, those who use them are identified only through series of random numbers and letters which are assigned to their digital wallets.

There is no way to identify who holds a specific wallet. This means that transactions also remain anonymous.

If you want to exchange bitcoins with conventional currencies such as the United States dollar, the British pound or the euro, you can do it by using several dedicated exchanges.

What are the purposes and uses of bitcoins?

Bitcoins can be a way to buy items. In fact, many normal businesses are accepting payments in bitcoins. Some examples include consumer electronics, hotels and travel resorts.

You can use bitcoins to buy many items. However, you could also buy and sell the currency to make a profit on its change in value.

Besides serving practical purposes, traders have recently begun to buy and sell bitcoins to make a profit.

Due to their growing popularity, bitcoins have significantly increased in value and this has led to traders being able to speculate on the future price.

As more and more people are attracted to the market, bitcoins can also be seen as a potential store of value. For instance, after the Cyprus banking crisis occurred in mid-March 2013, investors bought bitcoins in their search for an alternative place where to store their wealth.

How the bitcoin system works

Bitcoins transactions are verified through 'digital signatures'. This means that when you spend bitcoins, you use two keys: one public and one private.

The system works through digital signatures and the activity of mining. These two aspects allow transactions to be monitored and verified without a central administration.

When you send bitcoins to someone, you create a transaction which contains the public key of the new owner and you sign this transaction with your private key.

Through these two steps, the transaction is broadcast anonymously to the entire network of bitcoins users. At this point, everybody knows the new owner of the currency and that the transaction is matched by the holder's private key.

This mechanism provides security against thieving, but it does not prevent a user from spending a bitcoins twice – a problem known as 'double spending'.

In order to solve this issue without resorting to a central authority, the bitcoins network relies on the so-called 'miners'.

Miners process and verify all the network transactions in 10 minutes 'blocks'. These blocks are then added to a public ledger (the 'block chain') which records all successful transactions.

The task of mining is extremely complex. It requires substantial technical knowledge, as well as a lot of computing power and considerable electricity supply.

For this reason, miners receive a reward for successfully adding a new block of transactions to the block chain. This reward consists in 25 bitcoins.

Besides rewarding the miners for successfully adding a new block to the block chain, this process also represents the way in which bitcoins are created and injected in the system.

In other words, the bitcoins supply is generated and controlled through the very same mining activity.

Bitcoins are created through the very same activity of mining.

The growth of bitcoins as an industry

When bitcoins were first launched, $1 could have been enough to buy over 1,000 BTC. In other words, they were not worth much at all. Today, the situation is completely different. In fact, since its inception, the value has increased to a high of over $250.

Bitcoins show clear potentials for growth. This would be encouraged by several factors such as: the greater use of electronic commerce and virtual communities on the internet; the fact that bitcoins provide high level of anonymity, low transaction costs and a quick process of clearing and settlement.

However, obstacles to this growth are: the risks posed to price stability and financial stability; the possibility that regulators would clamp down the bitcoins project due to the risks it presents.

Bitcoins present many advantages which influence their growth positively. But, there are also risks which could hinder their expansion and use.

Risk warning: Trading in financial instruments carries a high level of risk to your capital with the possibility of losing more than your initial investment. Trading in financial instruments may not be suitable for all investors, and is only intended for people over 18. Please ensure that you are fully aware of the risks involved and, if necessary, seek independent financial advice. The educational content on Tradimo is presented for educational purposes only and does not constitute financial advice.